From page 284 to the end of the book Dr. Van Tharp goes over the effects that different position sizing strategies have on the same trading strategy.
He describes 4 position sizing methods:
Units per fixed amount of money- This model allows you to take one position per so much money. It basically treats all investments alike and always allows you to take a position. For example trading 100 shares for every $50k in my account.
Equal units model- This model gives an equal weighting to all investments in your portfolio according to their underlying value. Its commonly used by investors and equity traders. For example dividing my $50k equally into 5 and investing $10k into each stock or strategy.
The percent risk model – This model is recommended as the best model for long term trend followers. It gives all trades an equal risk and allows a steady portfolio growth. For example if I decide Im comfortable risking 2% of my $50k account equity and my stop loss is 10% on a $60 stock or $6 . I take ($50k account equity * 2% risk) = $1000 percent risk. ($1000 % risk/ $6 stop loss) = 166 shares to trade.
The percent volatility model- This model is best for traders who use tight stops. It can provide for a reasonable balance for risk and opportunity. This is similar to the percent risk model in that you risk a certain percent on a trade but the size position traded is determined by account equity percent divided by the average true range of the stock or market traded. For example if I decide to risk 2% account equity on a $50k account I risk $1000 if the ATR of the market Im trading is $10 my position size is $1000/ $10 = 100 shares.
Each one of these position sizing strategies has a maximum threshold when annual performance peaks and then beyond that point the account goes bust. All plungers eventually go bust!
As an example Dr. Van Tharp tested the same breakout strategy from 1981 to 1991 on the same basket of commodities with a million dollar account. The results are below.
Units per fixed amount of money- This model peaked at total profit of $30,919,632 or 38% annual gain with a $30k per unit size, any size larger than that took the account to zero.
The percent risk model –This model peaked at a total profit of 1,212,000,000 or 93.5% annualized gain using 25% of account equity per position. Percentage risk greater than 25% took the system into negative equity.
The percent volatility model- This model peaked at 1,034,000,000 or 90.7% annualized return using 5% volatility. A position size greater than 5% volatility caused the system to go into negative equity.
Below is a table that shows how much your account will have to gain to recover from a drawdown.
Some position sizing rules to follow:
- Trade small enough so that you are able to follow the system and not let your emotions get in the way. You need to have a clear head and trade as the system rules dictate.
- Risk the same % of account equity every trade
- Don’t game the system and make up your own rules, like trying to buy only when a trade goes into a drawdown. This guarantees that you will get caught in every losing trade and will miss every one of the best trades that never goes into a drawdown.
- Don’t add into a drawdown. Adding into a drawdown guarantees that you will have your biggest sized positions on for a loss and smallest positions on for the best trades that never go into a drawdown.